If you’ve ever purchased an investment property, you know that the total cost of acquiring the property can amount to significantly more than the contract price. Surprises on settlement day are never fun, so you need to make sure that you know exactly what to expect, and manage your cash flow accordingly.
Just as in any business endeavor, you would be wise to create a thorough budget before you even start shopping for a property. Your time is precious, and there’s no sense in wasting time looking at properties that you won’t be able to afford. In fact, knowing what you can afford is the starting point of determining which area you should focus on in your property search.
A buying budget will not only help you hone in on an area, it will empower you to know exactly how much of your own money you’ll need, as well as how much you’ll need to borrow from the bank to get the deal done. From there you can establish a cash flow plan and enter the transaction with your eyes wide open.
Here are five simple steps to establishing a buying budget:
1. Determine How Much You Can Borrow
Knowing your borrowing power is the starting point of determining the maximum purchase price of your property. How much you can borrow will be determined by your income, your credit rating, the specifics of your investment property, the type of loan you are seeking and the policies of the lender.
I’ve written extensively about the steps in gaining approval for an investment property here. At this stage; however, the primary goal is simply to gain pre-approval.
Be sure that you start with the right lender. Unless you already have an established relationship with your bank, it’s probably wise to start your pre-approval with a mortgage broker.
Before you sign on any dotted lines, make sure you’ve found your ideal loan product. Not all property loans are the same. Make sure your loan suits the purpose of your investment.
This is also a time to be proactive in preparing a strong loan application. It’s your responsibility to have your supporting documents to verify your income and credit claims. You should be aware of your credit history and make any repairs to ensure a favourable outcome.
Whenever possible, work closely with an insider in the lending institution. You want someone that knows the approval criteria; someone who will help you present your application in the best way possible.This could be as simple as working with a well-connected mortgage broker, or it could mean working directly with a bank manager in your town.
Being proactive before you actually need financing will greatly increase your chances of success.The pre-approval process not only gives you clarity on your buying budget, it allows you to identify and resolve credit and serviceability problems before it’s time to buy.
Keep in mind that a pre-approval is not a guarantee of finance. You will still need to go through the formal loan application process. In the end, you may or may not qualify for the loan amount and terms indicated in the pre-approval. However, it’s much better than starting from scratch.
2. Factor In Your Cash Savings And Other Sources Of Finance
Once you know how much you can borrow, you’ll want to add to that figure the total amount of the additional sources of finance at your disposal.
This may include cash in the bank or funds acquired through the liquidation of another asset. Also consider any lines of credit that you have available, money you might be able to raise through a joint venture partnership or any government grants.
Once you total all available cash together with your borrowing ability, this figure represents your maximum budget limit.
3. Itemise Acquisition And Improvement Costs
At this point, you’re still not ready to begin shopping for your property. You’ve only established the total amount you have to work with. The goal now is to establish the maximum purchase price of the property, after subtracting the acquisition costs from your budget limit.
Maximum Budget – (Acquisition Costs + Improvement Costs) = Maximum Purchase Price
In other words, if your maximum budget is $500,000, you can’t afford to go out and buy a $500,000 property. With a 20 percent deposit, your initial cash contribution is $100,000.
You will then need to add another 5 to 10 percent of the purchase price to cover settlement costs, such as stamp duty and legal fees. Since many lenders are unwilling to fund these closing costs, you may need to pay them in cash.
If you are planning a renovation or subdivision, you’ll need to factor in these improvement costs, as well. Depending on how much cash you have at your disposal, the percentage amount of your required deposit can have a significant impact upon your maximum purchase price.
Once you’ve determined a fair estimate of these costs, you’re ready for the next step.
4. Start Shopping for a Property
I was speaking with a builder recently who was telling me how he often has young purchasers come to him with their maximum purchase price, but they often tend to upgrade their inclusions to make sure they spend the full amount.
As an investor, your goal is not to spend your entire budget. Remember to be mindful of the profitability of the investment. Look for properties that fit within your deal profile and match your defined investment objectives.
Your buying budget is simply intended to set the parameters of your purchase and to focus your search accordingly.
5. Apply Your Budget To The Property
Once you’ve found a suitable property, you’ll need to double-check your previously budgeted acquisition and improvement costs to ensure they are correct.
List all of your costs and determine whether you will borrow the money or pay cash to cover each component. Work out the timing of each payment to ensure you have a solid cash flow plan in place before you buy.
Consider these two key questions at this point:
- Do I have enough cash to meet the deposit and additional costs?
- Do I have enough borrowing ability to fund the remaining shortfall?
Before submitting an offer, be sure to follow these four simple rules. If there’s any question as to whether you can afford the property to qualify for your loan, be sure to make your offer subject to finance approval.
The most challenging part of establishing a buying budget is to clearly and correctly itemise all of the additional costs associated with acquiring and improving the property.
In Steve McKnight’s Property Apprenticeship course, we have an entire session devoted specifically to establishing a buying budget. At the end of this session, Steve includes a Buying Budget Itemiser Template that covers all of the common costs associated with buying a property.